Chapter 8 - Working Capital Management

Question 1

What does a company’s working capital cycle depend on (4 factors)

Answer 1

• the balancing act between liquidity and profitability
• efficiency of management
• terms of trade
• the nature of the industry

Question 2

Caculating WCC

Answer 2

WCC= inventory holding(storage) period + trade rec’s collect period – trades payb pay period

Question 3

4 components of working capital

Answer 3

• Inventory (raw materials, WIP, finished goods)
• Trade receiveables
• Cash and cash equivalents
• Trade payables

Question 4

Types of inventory holding periods

Answer 4

• Raw material holding period = inventory of raw material (RM) ÷ cost of RM consumed per day
• WIP holding period = WIP inventory ÷ cost of production per day
• Finished goods storage period = inventory of FG ÷ cost of goods sold per day

Question 5

3 main signs of overtrading

Answer 5

• a rapid increase in revenue and the volume of current assets
• most of the increase in assets being financed by credit
• a dramatic drop in liquidity ratios

Question 6

Purpose of efficiency ratios

Answer 6

Measure how efficiently a company uses its assets to generate revenues and manage liabilities

Question 7

4 Main effiency ratios

Answer 7

Asset Turnover: ability to generate sales or revenues from its assets
AT = Revenue / net or total assets (non-current and current assets)
<br></br>Inventory Turnover: effectiveness of inventory management – how quickly sold/used in period – inverts ‘inventory holding days’.
IT = annual cost of goods sold / inventory
<br></br>Trade receivables collection – how quickly debts from customers collected
(TR x 365) / credit sales (or revenue)
<br></br>Trade payables collection - how quietly suppliers being paid
(TP x 365) / credit purchases (or cost of goods sold

Question 8

Main objectives of inventory management

Answer 8

Inventory management is a key aspect of working capital management. It is crucial for businesses as it has a direct
impact on profitability. The main objective of inventory management is to achieve maximum profits by maintaining
adequate inventory levels for smooth business operations, while also monitoring the levels to minimise the costs of
inventory holding. Holding too much inventory can result in the company’s cash being tied up in purchasing, storing,
insuring and managing inventory. It may also result in product obsolescence or waste, especially if the inventory is
perishable.
<br></br>
The key task of inventory management – striking a balance between holding costs and
costs of stock-out – involves determining:
* optimum re-order level
* optimum re-order quantity

Question 9

5 main techniques of inventory management

Answer 9

• economic order quantity
• ABC inventory control
• just-in-time systems
• fixing the inventory levels
• vital, essential and desirable analysis

Question 10

What is economic order quantity? (how it is calculated)

Answer 10

The economic order quantity (EOQ) focuses on maintaining an optimum order quantity for inventory items. The aim of
the EOQ model is to balance the relevant costs by minimising the total cost of holding and ordering inventory. The model
makes the following assumptions relating to its relevant costs.
<br></br>EOQ = √2 x C x D x H
* D = actual demand
* C = ordering cost per order
* H = holding cost per order

Question 11

Main assumptions of the EOQ model?

Answer 11

The model assumes that:
* demand and lead time are constant: this model will be ineffective for the business whose demand fluctuates
frequently;
* purchase price, ordering and holding costs remain constant;
* no buffer inventory is held or needed;
* seasonal fluctuations can be ignored; and
* inventory levels are continuously monitored

Question 12

4 levels of inventory ***

Answer 12

Minimum level
This is the lowest balance that should be maintained by the company at all times. This level ensures that production will
not be suspended due to lack of raw materials. While fixing the minimum level of inventory, one should keep in mind the
time required for delivery and daily consumption.
Re-order level
This is the level of inventory at which the company should make a new order for supply. It is between the minimum level
and the maximum level. When determining the re-order level, the minimum level and rate of consumption have to be
considered.
Re-order level = minimum level + (rate of consumption × re-order period).
Maximum level
This is the maximum inventory level that the company can hold at any point of time. The inventory should not be more
than the maximum level. If the level of inventory exceeds the maximum level, it increases the carrying costs and it is
treated as overstocking.
Maximum level = re-order level + re-order quantity – (minimum rate of consumption × minimum re-order period).
Danger level
This level is fixed below minimum level. The inventory reaches this level when the normal issue of raw material is
stopped and issued only in case of emergency. An immediate action must be taken by the company when the inventory
reaches danger level.
Danger level = rate of consumption × maximum re-order period in case of emergency.

Question 13

JIT SYSTEM OVERVIEW

Answer 13

The just in time (JIT) system is a series of manufacturing and supply chain techniques that aim to reduce inventory to an
absolute minimum or eliminate it altogether by manufacturing at the exact time customers require, in the exact quantities
they need and at competitive prices.The key objective is to reduce flow times within the production system as well as response times from suppliers and to customers. Reducing the level of inventory not only reduces the carrying
costs but, by using this technique, manufacturers also get more control over their manufacturing processes – making it
easier to respond quickly when the needs of customers change. JIT attempts to eliminate waste, capital being tied up in inventory and activities that do not add value by ensuring a smooth flow of work at every stage of the manufacturing and the production process. This also reduces storage and labour costs. <br></br>
Relationships with suppliers are an important aspect of the JIT system. If the supplier does not deliver the raw materials
in time, it could become very expensive for the business. A JIT manufacturer prefers a reliable, local supplier to meet
the small but frequent orders at short notice, in return for a long-term business relationship. JIT has very low inventory
holding costs (close to zero): however, inventory ordering costs are high.

`

Question 14

Drawbacks of JITS

Answer 14

Despite the magnitude of the preceding advantages, there are also some drawbacks associated with the JIT system.
* Since the manufacturer does not maintain high levels of inventoy, any price fluctuations in raw materials could make
the JIT system costlier.
* This model may not be helpful in cases of excess and unexpected demand, since it means few or no inventories of
finished goods are held.
* Production is highly reliant on suppliers. If raw materials are not delivered on time, it could become very expensive
for the business.
* It may need an investment in technology that links the information systems of the company and its suppliers.

Question 15

ABC INVENTORY CONTROL

Answer 15

ABC inventory control is an analytical approach for classifying inventory items based on the items’ consumption values.
Under this method of inventory management, materials are divided into three categories.
* A category items require high investment but only represent small amounts in terms of inventory items. Generally,
these items represent only 15% to 20% of inventory items but have a relatively high consumption (also referred to
as the 80/20 rule by the ‘Pareto approach’ where 80% of the output is determined by 20% of the input). Due to the
high value associated with A category items and the greatest potential to reduce costs or losses, these are closely
monitored and controlled to ensure these items are not over- or under-stocked.
* B category items represent 30% to 35% of inventory items by item type and about 20% of the value of
consumption. B category items are relatively less important than A items. However, these will be maintained with
good records and regular attention.
* C category items are the remaining items of inventory with a relatively low value of consumption. Usually they only
make up to 10% of the total value of consumption. C category items are ordered on a half-yearly or yearly basis. It
is not usually cost-effective to deploy tight inventory controls, as the value at risk of significant loss is relatively low.

Question 16

VED Analysis

Answer 16

VED stands for vital, essential and desirable. It is a popular technique, especially with companies at the start-up stage
who are working with limited resources and small budgets. Under-ordering can reduce the revenue stream while over-
ordering can lead to capital being tied up.
The key objective of VED analysis is to identify the criticality of inventory items that the business cannot operate without.
Inventory items are classed based on the degree of criticality.
* Vital: these are the vital items without which the production activities of the company would come to halt. These
inventories should always be kept in hand.
* Essential: these are essential spare parts but whose non-availability may not adversely affect production. Such
spare parts may be available from multiple sources within the country and the procurement lead time may not be
long.
* Desirable: desirable items are those items whose stock-out or shortage causes only a minor disruption for a short
duration in the production schedule. The cost incurred is very nominal.

Question 17

MANAGEMENT OF TRADE RECEIVABLES

Answer 17

In highly competitive industries, companies often use credit sales as a promotional tool. Trade receivables are debts
owed to a company by its customers for goods or services sold on credit. The management of trade receivables is a key
aspect of working capital management, as a substantial amount of cash is tied up in trade receivables. The ultimate goal
of trade receivables management is to maintain an optimum level of trade receivables by achieving a trade-off between:
* profitability from credit sales
* liquidity (reducing the cost of credit allowed)
<br></br>
The main purpose of managing trade receivables is to meet competition and to increase sales and profits, as long as the
costs of funding the additional credit do not exceed the returns. The objectives of trade receivables management are:
* to control the costs associated with the collection and management of trade receivables: administrative costs
associated with trade receivables include maintenance of records, collection costs, defaulting costs and writing off
bad debts;
* to achieve and maintain an optimum level of trade receivables in accordance with the company’s credit policies; and
* to achieve an optimum level of sales.

Question 18

5 factors affecting the size of trade receivables

Answer 18

• Size of credit sales: the primary factor in determining the volume of trade receivables is the level of credit sales
  made by the company. Trade receivables will increase with any increase in credit sales.
• Terms of trade: sometimes, companies make credit sales at higher prices than the usual cash sales price. This
  gives them an opportunity to make extra profit over and above the normal profit. If the company allows a customer a
  longer credit period than normal, then the trade receivables amount will also increase.
• Credit policies: credit policies are another major determinant in deciding the size of trade receivables. A liberal
  credit policy will create more trade receivables while the conservative or strict credit policy will reduce trade
  receivables.
• Collection policies: a company should have a strong and well-equipped credit collection system. Periodical
  reminders should be sent to the customers to reduce the trade receivables outstanding amounts. If proper attention
  is not paid to this, it will create potential issues such as additional cost on follow-ups or even the need to write off
  bad debts.
• Expansion plans: companies looking to expand their business encourage credit sales to attract customers. In
  the early stages of expansion, trade receivables are therefore usually at a high level. As the company becomes
  established, it may start reducing the credit period allowed.

Question 19

Factors to consider when setting credit policy (7)

Answer 19

• level of credit sales required to optimise profits
• market conditions
• competition
• credit period
• terms of trade
• trade and settlement discounts
• efficiency in record keeping

Question 20

key elements or variants of credit policy that should be considered

Answer 20

Terms of credit
Terms of credit are the stipulations recognised by the company for making credit sales to its customers. They provide an
agreement between a seller and buyer regarding the timing and amount of payments the buyer will make. It also covers
other aspects, such as early cash settlement discounts.
Credit limits should be set for each customer and monitored on a regular basis. A longer credit period increases the
working capital or cash operating cycle, thus increasing costs. However, customers prefer a generous credit period. The
optimum policy formulates a trade-off between cost and profitability.
Assessing creditworthiness
A company should investigate the creditworthiness of all its new customers by checking their previous track record or
credit files. This should be reviewed and monitored at regular intervals. Alterations to the credit terms should be made if
necessary. Businesses use corporate credit rating agencies such as Dun & Bradstreet to assess the creditworthiness of
their customers.
Collection policies
A credit period only begins once an invoice is issued to the customer. Prompt invoicing is essential. The risk of default
increases if debts are allowed to go overdue: therefore, a system of follow-up procedures is required. A stringent collection procedure is expensive for the company because of high costs but it reduces bad debts. A lenient collection process attracts customers, but it has a higher risk of bad debt write-offs. An optimum collection policy can be formulated
by balancing the cost and benefits. A collection process can be costly due to the lengthy steps involved. Most companies
typically follow a collection procedure as demonstrated in Figure 8.6.

Question 21

MANAGEMENT OF TRADE PAYABLES !!!!!!!!!!!!!!!!

Answer 21

Managing trade payables is a key part of working capital management. The objectives of the management of trade
payables are to ascertain the optimum level of trade credit to be given and to support mutually beneficial relationships
with suppliers.
<br></br>
Deciding on the level of credit to accept is a balancing act between liquidity and profitability. Companies must consider
the following factors in making the decision for the optimum level of trade payables and for the effective management of
trade payables.
* Maintaining good relations with regular suppliers is important to ensure continuing supplies as and when required.
* The flexibility of available credit should be considered as it can be used as short-term finance when the company
has a cashflow shortfall.
* Trade credit is the simplest and most important source of short-term finance for many companies. By delaying
payment to suppliers, companies can reduce the level of working capital required. However, by delaying payments,
a company risks its credit status with the supplier. This could result in supplies being stopped. It could also lose the
benefit of any early settlement discount offered by the supplier for early payment.
* All other factors that could impact the overall cost of delaying payments must be considered: for example, whether
interest is charged on overdue supplier accounts.
* Early settlement discounts should be taken up where possible. The discount is given when payables are promptly
paid within the specified terms. However, a company might wish to maximise the use of the credit period allowed by
suppliers if the firm is short of funds, regardless of any settlement discounts offered. When a choice of discount is
given, the annual cost of a discount must be compared with the additional interest cost of paying the debt early (see
Chapter 9).
* Management can use the trade payable days to control and to help monitor the level of trade payables.
* Companies should have sufficient liquidity to guarantee that trade payables can be paid off when they fall due. The
current and quick ratios and the trade payables payment period ratio are all helpful in analysing the efficiency of
management of trade payables.

Question 22

Loan Covenants (MOVE THESE TO CHAPTER 9)

Answer 22

A term loan is conditional on a loan covenant. A loan covenant places a restrictive clause in a loan agreement that
places certain constraints on the borrower, with reference to:
* financial reporting : requiring lenders to submit management reporting, including cash flow and forecasts, on a
regular basis (such as every quarter);
* financial ratios: getting debt or liquidity ratios within an agreed range or requiring working capital to be maintained
at a minimum level;
* regulatory reporting: requiring the statutory financial statements to be audited annually; or
* debt covenants: restricting the borrower’s ability to take on more debt without prior consent of the lender or
forbidding it from undertaking certain activities.

Question 23

Advantages of bank/institutional loans

Answer 23

• Loans can be set up in a short space of time, providing access to money quickly.
• Businesses normally prefer unsecured loans as they are considered less risky than loans with longer terms.
• They are good for budgeting as they require set repayments spread over a period of time.
• Loans have more flexible terms than some other sources of short-term finance. For example, they may provide the
  option for interest-only payments with the balance of the loan to be paid off at a later date.
• Banks do not put as much emphasis on the credit history of the business as they do for longer-term loans.
• Loans do not require giving up control of or a share of the business.
• Interest and arrangement fees are normally tax deductible.
• They are usually not repayable on demand unless defaulted.

Question 24

Disadvantages of bank/institutional loans

Answer 24

• Short-term loans usually have higher interest rates than long-term loans.
• Loans can compound debt problems if a business cannot obtain cheaper long-term finance.
• Defaulting on repayment can damage credit status.
• A term loan is conditional on a loan covenant. The bank can demand repayment of the loan if the business defaults.
• There is normally an extra charge for early repayment.

Question 25

Advantages of overdrafts

Answer 25

• Overdrafts are easy and quick to arrange with immediate access to funds.
• Unlike many loans, an overdraft can normally be cleared anytime without an early repayment penalty.
• They serve as backup against unexpected expenditure.
• The bank normally allows for an interest-free period with interest paid only on the overdrawn balance.
• They do not require giving up control of or a share of the business, unlike equity financing arrangements.
• Interest and arrangement fees are normally tax deductible.
• Due to its short-term nature, an overdraft balance is not normally included in the calculation of the business’s
  financial gearing.

Question 26

Disadvantages of overdrafts

Answer 26

• Interest is unpredictable as it depends on a variable interest rate and on the amount overdrawn on each day of the
  charging period.
• Overdrafts are repayable on demand without prior notice, although this is unlikely unless the business experiences
  financial difficulties.
• A higher rate of interest is charged for using the unauthorised facility.
• Banks often charge an annual arrangement or maintenance fee for providing an overdraft facility.
• Larger facilities will often need to be secured, depending on the lender and the business’s level of risk.
• Failure to pay the interest charges or going back into credit on a regular basis can lead to a fall in credit score

Question 27

What is debt factoring?

Answer 27

Debt factoring, or invoice factoring, is a financial arrangement whereby a business sells all or selected trade
receivables at a price lower than the realisable value to a third party, known as the factor, who takes responsibility for
collecting money from the customers. The arrangement provides an immediate source of cash to the business selling its
trade receivables.

Question 28

What are the 2 types of debt factoring?

Answer 28

• With recourse: the borrower maintains control over the trade receivables and collects from customers. The
  factor assumes no responsibility for bad debts. Credit risk of non-payment by the debtor is borne by the borrower
  and trade receivables are essentially used as collateral. This approach is least visible to customers and allows
  borrowers to keep customers from knowing about any factoring arrangements.
• Without recourse: the factor maintains control and bears the responsibility for bad debts and any risk of non-
  payment, subject to the payment of an additional fee. The lender advances a certain percentage, normally around
  80% of the value of the debt, within two or three days of the factoring arrangement. Besides the assured cash
  flow, the administrative burden of the supervision of trade credit is reduced, which may be important for small
  and growing businesses. The lender monitors all trade receivables due from the customers of the borrower and
  has payments sent to the lender’s designated location. The factor subsequently pays over the balance, less its
  administration costs, to the company.

Question 29

Advantages of debt factoring

Answer 29

• Debt factoring provides an immediate source of finance.
• It is particularly useful to companies that are expanding rapidly, as it will leave other lines of credit open for use
  elsewhere in the business.
• Start-up businesses and SMEs can benefit from factoring when they cannot gain access to other forms of cheaper
  finance.
• Debt collection, when outsourced, can increase cash by providing savings in credit management and certainty in
  cash flows.
• The factor’s credit control system can be used to assess the creditworthiness of both new and existing customers.
• Reduces the probability of bad debts for the company.
• Non-recourse factoring allows for insurance against bad debts.

Question 30

Disadvantages of debt factoring

Answer 30

• Factoring can be expensive, with costs normally running at between 2% and 4% of sales revenue.
• Debt collection, when outsourced, raises fears about its viability. This may endanger the company’s trading
  relationships with customers who may not wish to deal with a factor.
• The company risks losing control over its trade receivables and granting credit to its customers.
• The company still bears the risk of non-payment in factoring (with recourse) where credit risk of non-payment by the
  debtor is borne by the business.

Question 31

What is invoice discounting?

Answer 31

Invoice discounting and factoring are both ways of speeding up the collection of funds from trade receivables. However,
unlike factoring, invoice discounting does not use the sales ledger administration services of a factor.
Invoice discounting, also referred as ‘bills discounting’ or ‘purchase of bills’, is a short-term borrowing arrangement
whereby a company can borrow cash from financial institutions against invoices raised with customers. The company
uses unpaid trade receivables as collateral.
Generally, a company can use up to 80% of the value of all invoices which are at less than 90 days to borrow within 24
hours. The finance company relies on a spread of trade receivables among many customers. The actual percentage
and duration may vary. While specialist invoice discounting providers exist, this is a service also provided by a factoring
company.
Invoice discounting is a quick way to improve cash flow but may cause management to lose focus from the administrative
and compliance aspect. Invoice discounting should be used as an additional facility. The key focus should be on
improving credit control to improve the working capital cycle and liquidity.

Question 32

Advantages of invoice discounting.

Answer 32

• Invoice discounting is a quicker method to procure cash than through loans and overdrafts (which often require a
  credit check).
• It provides significantly more cash than a traditional bank.
• It accelerates cash flow from customers, since generally up to 80% of the invoices can be converted into cash.
• No non-current assets are required as collateral – borrowings are against sales invoices.
• Invoice discounting allows more room for credit sales by making such sales more liquid.
• The borrowers maintains control over the trade receivables.
• Confidentiality of the arrangement can be maintained.
• The company can obtain the cash it needs while also allowing the normal credit period to its customers.

Question 33

Disadvantages of invoice discounting.

Answer 33

• The additional fees charged by the discounting providers decrease the company’s profit margin.
• Excessive reliance on invoice discounting may not be taken very positively by all stakeholders. It can give the
  appearance of the borrower struggling with finances.
• As it is available only on commercial invoices, payments owed from the general public may not be eligible for
  invoice discounting.
• When a business relies heavily on invoice discounting, it may cause management to lose its focus from
  strengthening its credit norms.

Question 34

What is invoice trading third-party payment?

Answer 34

Peer-to-peer invoice trading is a new type of invoice finance where businesses (usually SMEs) auction their outstanding
invoices via centralised online platforms such as MarketInvoice and Platform Black to obtain immediate cash to boost
their working capital.
It provides an online solution that connects businesses selling invoices with investors lending against those invoices
for an attractive return. The platform charges a fee from both the businesses and the investors for the service provided.
It provides finance more cheaply and quickly than from traditional providers. Like factoring, businesses receive funds
against invoices without having to wait for the invoices to be settled.

Question 35

Difference between factoring and invoice trading third-party payment?

Answer 35

Unlike factoring, invoice-trading platforms provide finance against individual invoices rather than signing clients up for
long-term contracts. There are no setup or termination fees. The business is in control of the number of invoices they sell
on a pay-as-you-go basis. Funds can be accessed the same day, with easy applications and online administration.

Question 36

Advantages of alternative financing (crowdfunding, p2p, invoice trading third party payment)

Answer 36

• Alternative finance provides quick access to money with online applications.
• It provides new and innovative ways to connect borrowers and investors via the internet.
• It can save businesses from unexpected financing distress.
• It provides access to funds previously unavailable by use of non-traditional forms of determining credit worthiness,
  often in conjunction with credit reports.

Question 37

DIsdvantages of alternative financing (crowdfunding, p2p, invoice trading third party payment)

Answer 37

• Alternative financing is not subject to regulatory reporting requirements in many jurisdictions.
• It costs significantly more than annualised rates associated with conventional financing – anywhere from 30% to
  50%.
• The amount of money that can be borrowed is quite limited (typically less than £100,000).
• Small businesses simply may prefer working with more established, well-recognised institutions.
• Lenders are subject to increased risk losses due to fraud.
• The market is still evolving with new platforms carrying the different level of risk for both lenders and borrowers.